Tuesday, January 14, 2014

If you are like many Americans, you made a New Year's resolution, and, if you are like most of those people, you will have given up on it before the year is half over. Traditional economic analysis would attribute this result to a difference between what was expected and what actually happened. Either the benefit of maintaining the resolution wasn’t as great as expected, or the cost of maintaining it was more than expected. While considering benefits and costs is always a good place to start when trying to explain why something happens, this explanation feels incomplete. If it were solely a matter of benefits and costs, we would be far less hard on ourselves when we broke our resolution. Moreover, the difficulty of following through on our intentions probably wouldn’t have been considered an interesting problem by a Nobel laureate. Thomas Schelling, who won the Nobel Prize in Economics in 2005 for his contributions to game theory, postulated in “Egonomics, or the Art of Self Management" that we behave as if we have two selves: The one who wants to achieve a goal, despite its costs, and the one who wants to give up on the goal when faced with those costs. As examples, he wrote that there is "the one who wants clean lungs and a long life and another who adores tobacco" and there is the “one who wants a lean body and another who wants dessert. The two are in a continual contest for control.”Schelling suggested a classic way to overcome the problem of having two selves: Taking away decision-making ability from the “wayward” self by having the “goal-setting” self pre-commit to certain actions:

Locking away a high-calorie treat so that it is not immediately accessible;

Setting the alarm clock across the room so that we have to get out of bed to turn it off

Pre-ordering a healthy lunch right after breakfast, when an unhealthy choice is least tempting

Since the time that Schelling wrote about these tricks, behavioral economics has provided more insight about why they are useful, and technology has made it easier to implement them. There is analarm clock that rolls away from you until it is turned off, and there are low-cost safes with time-based locks on them, so that you can lock away a treat until later.The internet has also made it easier to access tools that boost our resolve. To increase accountability and muster support from his friends, New York Times reporter Brian Stelter tweeted everything he ate in 2010 and ended up losing 90 pounds. For those who need higher stakes to follow through, economists at Yale founded stickk.com, where you can specify that money be donated to a charity you don't like whenever you don't meet your goals. (Why not a charity that you do like? Because then your failure of resolve wouldn't be as costly, making it less unpleasant to give in.) The proliferation of location-aware smartphones has enabled apps like GymPact, which pays you for checking in at the gym when you said you would, where the funds come from those who committed to working out but ending up skipping.Of course, the internet and smartphones have also made the resolution to maintain focus more difficult. We are always only one website or app away from distraction. Fortunately, there are browser extensions, such as StayFocusd for Chrome and LeechBlock for Firefox, that you can use to limit your access to the internet.Despite all the forces that make it difficult to keep a resolution, there is still a benefit to making one. Research suggests that those who make a formal resolution are 10 times more likely to succeed in changing than those who do not make a resolution. If your goal-setting self makes a resolution this year, I hope you find this blog post helpful when your “wayward” self wants to break it.Resources:Not surprisingly, psychologists also have a lot to say about keeping resolutions, especially with the growing insight that willpower is like a muscle: in the short term, it gets tired with use, but in the long term, use makes it stronger. This article provides advice based on recent psychological research.

Monday, November 25, 2013

Economists are famous, perhaps infamous, for disagreeing with each other. Indeed, economists have
different views on policies, different scientific judgments, and different values. Even economists who share the Nobel Prize in Economics sometimes disagree with each other. This year the prize was given to Eugene Fama, Lars Peter Hansen, and Robert Shiller for highly influential but contradictory theoretical and empirical analysis of asset prices. The huge importance of their research stems from our every day choices between saving in the form of cash, investing in stocks, and real estate. Our decisions depend on our evaluation of the risks and returns associated with these forms of saving. Modern economy also depends on the understanding of asset prices as they provide information for key economic decisions regarding physical investments and consumption. Mispricing of assets leads to financial crises and can damage the overall economy.

The differences in the laureates’ research are well known in the finance community. They also have quite different policy implications. Answering the surprised public, Robert Shiller wrote “We disagree on a number of important points, but there is nothing wrong with our sharing the prize. In fact, I am happy to share it with my co-recipients, even if we sometimes seem to come from different planets.”(http://www.nytimes.com/2013/10/27/business/sharing-nobel-honors-and-agreeing-to-disagree.html?_r=1&).

In the center of the disagreement is the question of whether asset prices are predictable. Clearly, you can make a lot of money if you can predict with a high degree of certainty that one asset will increase more in value than another one. In the 1960s, Fama advanced the efficient-markets theory, which states that prices reflect all publically available knowledge, which implies that average investor can’t beat the market. It also implies that prices follow a random walk, go up or down, which makes deviations from expected returns unpredictable and arbitrage impossible. Fama’s empirical studies supported very limited short-run predictability in stock markets. Even if an asset’s actual price goes above or below its expected price, such deviations are so small that trading costs would exceed any gains from arbitrage. Many concluded that if prices are virtually impossible to predict in the short run, they are even less predictable over longer time horizons. A practical take away from the efficient market theory is that trading by using complex algorithms is no better than by just flipping a coin. You can accidentally have a long series of luck but publicly available information will not ensure you could systematically beat the market. However, in the 1980s, Shiller’s studies of stock-price volatility and longer-term predictability challenged this conclusion. He showed that stock prices exhibit excess volatility – that is, prices significantly deviate from the expected levels in response to events affecting asset prices, such as dividend news – in the short run, and over a few years the overall market is quite predictable. On average, the market tends to move downward following periods when prices are high and upward when prices are low.

Moreover, Shiller suggested some behavioral explanations for asset prices’ excess volatility, which inspired a new field called behavioral finance. For example, he suggested that there are two types of investors: experienced rational investors and so-called “ordinary investors.” Unlike rational investors, the ordinary ones fail to recognize and utilize arbitrage opportunities. Instead of responding to expected returns, they are highly susceptible to the opinions of others about stock prices, similar to fads or fashions. As a result, their trades exacerbate deviations of stock prices and generate excess volatility, which generates arbitrage opportunities for others.

One of the most difficult issues in modeling financial markets is uncertainty. The theory acknowledges that investment decisions involve risk but they also assumes that investors are aware of how markets work and have access to the true data, which allows them to process information efficiently. In real life, we have to deal with very limited information, as there are too many variables that we can neither observe nor measure directly. Hansen has made a lot of progress developing and testing a variety of asset pricing models which allow studying complicated systems with limited information. (http://business.time.com/2013/10/23/nobel-prize-winner-lars-peter-hansen-on-how-economics-has-helped-you/#ixzz2kZ4KXLni )

Why did the Nobel Committee decide to award a joint prize? Fama, Hansen, and Shiller explored price predictability from different angles and produced important empirical findings with important practical implications. For example, Fama’s research inspired the creation of index funds – mutual funds tracking the performance of a particular index, a convenient way to participate in the stock market and diversify a portfolio – in the early 1970s, which has grown to account for over 40% of the worldwide flows into mutual funds. In turn, Shiller’s research is behind the S&P Case-Shiller index that is now the standard real estate price index in the United States. So, it looks like we are from the same planet, after all.

Discussion Questions

1. Why do some people gamble regularly while others would never even consider making a bet?

2. Why are behavioral economics, for which Vernon Smith and Daniel Kahneman received a Nobel Prize in 2002, and now behavioral finance gaining more popularity in the academic and business community?

3. If you had $500 to invest, how much would you invest in an index fund and how much would you put in an individual stock that you thought was going to perform well?

Tuesday, October 01, 2013

The
Federal Reserve's decision on September 18th to continue purchasing $85 billion in
longer-term bonds each month took financial markets by surprise. Collective
wisdom expected that the Fed would begin tapering its purchases of U.S.
Treasury bonds and mortgage-backed securities—a policy first begun in the
aftermath of the financial crisis and known as quantitative easing—and thus, slowing its expansion of the money
supply. Instead the Federal Open Market Committee, which determines monetary
policy for the Fed, decided that unemployment was still high enough and
inflation still low enough to justify a continued expansion of the money supply
at the current rate.

It
remains to be seen whether the policy will have its intended effect on the
economy, but its impact on financial markets can be seen in price spikes at the
time of the announcement.

Because
market participants expected the Federal Reserve to demand fewer US Treasuries
in the future, the price for bonds in the future was expected to be lower than
now. In turn, the expectation of lower prices in the future had decreased
demand for bonds now, putting downward pressure on current bond prices. If the
Fed had acted as the market anticipated, the Fed’s announcement would have had
only a minimal impact on prices. When the Fed instead indicated that it would
maintain its demand for bonds, buyers and sellers of bonds realized that the
future price of bonds would be higher than they expected, and since the future
price was going to be higher, owning bonds now suddenly became more attractive.
As a result, the current demand for bonds increased, pushing the price of bonds
up. This price change can be seen in the graph of an indicator of average bond
prices, which shot up just after 2pm Eastern time, when the Federal Reserve
made its September 18th announcement.

(Click image to enlarge.)

Because
the effective interest rates paid by bonds decrease when bond prices increase
(check your textbook or watch this
video from the Khan academy for an
explanation of the inverse relationship between bond prices and interest rates),
the yield on longer-term US Treasury bonds declined on Sept 18, as can be seen
in the screenshot below.

(Click image to enlarge.)

Also
notice how low the short-term interest rate is: one-hundredth of 1% for 1-month U.S.
Treasury bills. This extremely low rate is another sign of the Federal
Reserve's desire to stimulate the economy. In fact, if it could set short-term
interest rates lower, it probably would. Instead, since nominal interest rates
cannot go below 0% (if they did, you would be paying banks to keep your money
with them), the Federal Reserve purchases longer-term bonds in an attempt to
give the economy extra stimulus beyond extremely low short-term interest rates.

If
the Fed is unable to reverse it later, this extra monetary stimulus will lead
to higher inflation. Since gold is traditionally a hedge against inflation
(that is, an asset that maintains its real value when prices increase), fears of
higher inflation tend to increase the price of gold. As a result, the spike in
bond prices due to the Fed’s announcement was accompanied by a spike in gold
prices. (Note: the difference in timing on the horizontal axes of the graphs is due to differences in time zone and how often data on prices is collected.)

In
an upcoming post, I'll look at how the Fed's decision to extend quantitative easing changed foreign
exchange rates, which was actually how I was alerted that the Fed had made a surprise
announcement in the first place.

Discussion questions:

How do you think the Fed's decision to extend quantitative easing affected the foreign exchange market? Did the US dollar appreciate or depreciate?

What other markets might have seen dramatic changes due to the Fed's decision?

Ben Bernanke, the Chairman of the Federal Reserve, has stated that he wants monetary policy to be more transparent. What does the financial market's reaction to the Federal Reserve's announcement suggest about the transparency of monetary policy?

Tuesday, September 03, 2013

The Chicago Cubs hold the record for
the longest championship drought in the four major US sports, not giving their fans a World Series victory since 1908. But for as much heartache and disappointment the team has given its fans over the years, it also offers the local community something uniquely positive; what economists call a positive externality.

The Cubs have played their home games in Wrigley Field since 1916, two years after the iconic ballpark was built. The stadium sits right across the street from apartment buildings that rise above the outfield bleachers. Residents high enough up in the buildings or people on the roof can see into the ballpark and watch the game as it’s being played. That unique view of the ballpark action led some entrepreneurial building owners to put bleachers on their roofs and sell tickets.

Economically, the good the Cubs produce (the entertainment provided from watching baseball games) is non-excludable because the private firm (the Cubs) cannot prevent some people from consuming the good without paying. When people other than the consumers that purchase any good, gain something from the good’s production, economists call that a positive externality.

Firms that produce goods that give positive externalities do not receive the full economic reward associated with producing the good because they are not paid by everyone who uses it. Those firms can increase profits if they can find a way to make their good excludable and thus, deny the “free” use of their good.

As of the start of this season, it appears the Cubs might be trying to do just that. As a part of a planned stadium renovation, the Cubs have proposed building a large scoreboard that will block the views from neighboring rooftops. Aside from increased advertising that the new scoreboard would bring, it should also help to make their good scarcer and increase demand for tickets, driving prices up.

Where does the story go from here? The team hopes to begin construction this fall, but owners of neighboring buildings have threatened legal action, saying a new scoreboard will “drive them out of business” though it’s possible that an agreement which benefits all the firms involved can be reached (either privately or with the help of local government) before the issue goes to court.

Discussion Questions

Suppose that the Cubs could determine the number of home games they play based solely on attendance, rather than by a schedule set by Major League Baseball.

1. In this scenario, if the team does not get paid when people watch the game from rooftop seats, will the number of games played be socially optimal? What if the team does collect money from rooftop viewers? Explain why.

2. When the outcome is not optimal, will there be too many games played or too few?

3. Propose a policy that the local government could implement to fix the inefficiency and get the team to produce the socially optimal number of games.

4. Economists say a good is rivalrous if one person’s consumption of the good prevents another person from enjoying it. For example, you and I cannot eat the same hamburger. Would you consider the good the Cubs produce to be rivalrous? Does the way a fan sees the game influence your answer?

Monday, June 24, 2013

Recently several California towns and counties introduced new rules concerning single-use grocery bags in an attempt to reduce the harmful effects of paper and plastic refuse on the environment. Plastic bags are banned completely while stores are required to charge 10 cents for each recyclable paper bag the customer wants to use. Proponents of the new policy argue it will reduce harm to marine life, damage to utility systems, reduce litter and waste, and conserve natural resources. The opponents, however, maintain that single-use bags are not only convenient for shoppers but actually serve multiple purposes after the initial usage, ranging from waste basket and cat litter containers liners to bike seat covers. The opponents also argue that the ban on plastic bags will boost consumption of a variety of plastic products to substitute for plastic grocery bags, which is not only costlier at the individual level but also might inflict more harm on the environment. The research on both sides of the argument is still inconclusive and lacks hard evidence. However, economic theory might yield some insights and help us see the much needed middle ground.

What we know with certainty is that at the individual level, people benefit from using single-use grocery bags. We also know that prior to the ordinance’s passage, the bags were given indiscriminately and for free. But the bags are also arguably bad for the environment and require recycling, and thus are costly to society. In economic terms, this means the bags create a negative externality – a cost that is not born by the consumers who enjoy the benefits of this product, but by society at large. This cost likely exceeds the benefit from using them.

The graph shows marginal social cost of and demand (or marginal private benefit) for single-use bags in the economy. Suppose that the quantity demanded is 100 billion shopping bags every year when they are given away for free (i.e. when price equals zero). According to some research, this might not be far from the truth for the United States. Suppose that at this quantity, the marginal social cost is 20c per bag, which exceeds the marginal benefit and is therefore not optimal. The law of demand dictates that charging for the bags will reduce consumption. Suppose that a fee of 10c per bag reduces consumption to 50 billion bags, equating the social costs and private benefits of single-use bags.

The 10c fee per paper bag is nothing but a Pigovian tax (named after the English economist Arthur Pigou) as it counteracts the negative externality. If the amount of the tax is set equal to the cost brought about by the negative externality, it will produce an efficient outcome: Only those who value the convenience of having grocery bags ready at the checkout enough to pay for the harm the bags cause will purchase them.

So where does the 10c fee come from? And why ban plastic bags completely instead of charging a fee for them as well? For one thing, the negative externality created by a paper bag is relatively easy to calculate. Since paper decomposes quickly without producing lasting damage to the environment, its harm equals the cost of recycling. So, there is a good reason to believe that the 10c tax is efficient enough. Unfortunately, plastic is another matter. The negative externality from plastic bags exceeds the cost of recycling as it also includes the damage to the environment done by discarded plastic bags, which is difficult to estimate accurately. In the absence of reliable cost information, it is hard to calculate an optimal Pigovian tax. Therefore, it seems reasonable to ban free plastic at the stores and let the market decide the price for substitute products.

Discussion Questions

1. Are single-use grocery bags normal goods?

2. What if the actual negative externality from a paper bag is less than 10c?

Wednesday, May 22, 2013

It’s a good thing I don’t have to watch my cholesterol, because after moving to the Maine seacoast last July, I simply cannot get enough lobster. Though I haven’t had to worry about the health cost of consuming lobster, I have been paying attention to changes in the dollar cost over the course of the season. Monitoring prices doesn’t get any easier for this lobster-loving Mainer because every day on the way to my son’s school, I drive by a sign advertising the current price.

The start of the lobster season coincides with an increase in the demand for lobster as summer vacationers head to the Maine beaches. In York, Maine, alone, the population triples during peak season then drops back down again once the school year begins. An increase in demand means upward pressure on price, while an increase in supply means downward pressure on price.

As lobster season came to a close in the summer of 2012, however, word on the street was that there was a surplus of lobsters. With quantity supplied larger than quantity demanded, downward pressure dropped lobster prices to an astonishingly low $2.99/pound for chix (lobsters weighing between 1 and 1.24 pounds), making lobster in southern Maine cheaper than a good steak at the time.

As lobster season ended and the bitter winter set in, the per-pound price of lobster started to tick upward. This is consistent with the basic model of supply and demand—once lobster season was over, supply decreased which put upward pressure on prices and demand decreased which put downward pressure on prices . Over the last year, it appears that supply changes have been more drastic than demand ones, thus the same good that had cost roughly $3 per pound in the summer cost nearly $10 per pound by March 2013 simply because of changes in supply and demand.

Between summer and winter, supply changes outweighed demand effects in the market for Maine lobsters (as evident in the large increase in price), so I am hopeful that lobster prices will drop in the coming months as supply increases so that I can enjoy my favorite butter conduit once more!

Discussion Questions

1.Using a supply and demand diagram, illustrate the shifts in demand and supply after the lobster season ends. Be sure to pay attention to the magnitudes of your shifts so that the equilibrium price rises as described in the article.

2.If lobster fishermen have a bad catch this summer, what would you expect to happen to the price of lobster in Maine in July?

3.How do fluctuations in the market price for lobster affect other markets for food products such as steak and chicken?

Wednesday, May 01, 2013

The other day I took my car to the mechanic for what I thought would be a quick maintenance appointment. However, I was sadly mistaken when my bill came in at a whopping $800. Because my knowledge of cars is pretty much limited to things that can be done from the driver’s seat, whatever fluid replacement, alignment adjustment, or component repair the mechanic recommends, I usually pay for with resignation. After reviewing my itemized bill, I wondered whether it really should have cost $30 in labor to replace my windshield wipers, whether my something-or-other-belt really needed to be replaced, or whether I could have perhaps gotten a cheaper set of new tires at Costco. It’s possible (if not quite likely), that a more informed consumer could have saved hundreds of dollars on the same transaction. And yet, it’s unlikely that I’ll do anything differently the next time I go in for repairs.

In many aspects of life, there are ways to save money by becoming more informed about what we’re buying or by learning how to do something ourselves rather than paying for the good or service. For example, a friend of mine learned how to fix guitars because, as a musician, this will save him from having to pay for a lifetime of professional repairs. Personally, I like to cook, and thus I save money by preparing my lunch at home rather than buying it at work. However, my musician friend doesn’t like to cook and therefore spends more money on pre-made lunches than I do, and uses the time he saves by not cooking to engage in activities more valuable to him.

This illustrates one of the fundamental principles of economics: we gain from specialization in the face of scarcity because everything has an opportunity cost. In this case, the opportunity cost of becoming more informed about cars is the time I spend learning about cars rather than doing other activities I enjoy. Given the limitations of time and money, no one can become an expert in everything. To be truly self-sufficient would require a return to our hunter-gather roots when we spent the majority of the day finding food, and even then you might want to assign someone to gather the berries, someone else to prepare the meal, another to build shelter, etc.

A common misperception is that economics is aimed solely at maximizing profit. However, a classic application of economics is the study of how people choose to spend their money and time given the limitations they face in order to maximize utility, or a person’s level of happiness. Because there are not enough hours in the day to find the cheapest way to do everything ourselves, we decide to spend our time either doing things we enjoy (that is, that directly give us higher “utility”) or getting paid to do things we are particularly good at (that is, tasks in which we have a comparative advantage). With the money we earn from working, we can then pay others to get the rest of what we want or need.

Discussion Questions

1. What are some of the things you choose to “specialize in” that others pay for? What are some of the things you pay for that perhaps you could do yourself? Are there other reasons for specializing in something besides being good at it or enjoying it?

2. The exact opportunity cost of an activity can be hard to determine, since it is not easy to put a “value” on your time. How is the opportunity cost of time different for someone who earns a fixed salary versus someone who can always choose the number of hours he or she works?

Friday, March 29, 2013

“Buyers know what goods cost.” Some version of that assumption comes up in the very first weeks of just
about every introductory econ course. It becomes one of the few assumptions that we make to build the model of consumer demand. But every once in a while, life gets in the way and asks “Is that something you really can assume?”

I had to test that assumption recently. I just moved and after unpacking, I was in the mood to make dessert for myself. Of course, I hadn't brought many kitchen supplies with me, so that quickly posed a problem. To make cookies, I needed to buy some wooden spoons, measuring cups, and a cooling rack. None of those are hard items to find, and I happened to live just minutes away from a shopping center that had a regional grocery store, a Wal-Mart, a Target, and a regional department store. I knew that all four stores should have what I want, so the question of where to go really came down to where it would cost the least. And that’s when I realized that one of the most basic assumptions of microeconomics didn't hold true. I didn't know which store would be the cheapest, or even what the prices of the goods should be!

I had some free time on a Saturday and a strong enough curiosity that I wanted to sample prices from each store. Here’s what I found:

STORE

WOODEN SPOON
(Dollars per spoon)

COOLING RACK
(Dollars per rack)

MEASURING CUPS
(Dollars per cup)

GROCERY STORE

$1.50

$4.50

$1.22

WAL-MART

$2.97

$2.99

$1.32

TARGET

$2.03

$3.67

$4.97

DEPARTMENT STORE

$12.00

$7.00

$7.50

I was also shocked by the spread in prices. While I did expect to see some markup at higher-end stores, the range was wider than I expected. I was also surprised that there wasn't one store that had the cheapest prices, across-the-board, for all the goods.

When economists create models, the goal is to make a few assumptions about the world to describe the “typical” human response and show how that response leads to a “general” outcome. My behavior in this case is not what economists would call “typical.” (My friends might even call it weird!) But even for the typical consumer, are the assumptions of the supply and demand model always appropriate?

In a lot of cases, the classic supply and demand model does gives accurate results, but sometimes the assumption that consumers know the distribution of prices isn't appropriate. In those cases, it’s important to understand how behavior will change if an assumption is violated. The classic model does not involve consumers looking for prices, they just know them. As economists, we often say we are assuming “complete information.” When consumers don’t have complete information the market price typically doesn't match the equilibrium price the model predicts. Most of the time the market will be inefficient (contrary to what the model suggests) and both producer and consumer surplus will be lost.

Throughout economics, every conclusion that we draw from a model depends on the assumptions that are used to build that model. Whenever I learn about a new model, I always list the assumptions made and focus on how the results change if the assumption would be removed. Understanding the relationship between assumptions and results is the critical step to applying what we learn from theory and using it to understand what happens in the real world.

DISCUSSION QUESTIONS:

1. When I was getting my information I found that stores rarely carry the exact same goods. (Even if they are the same brand, the packaging might be different. It’s why I calculated my information in per unit prices.) Since I was able to find the goods in multiple locations, but they were not identical, which market structure is the most appropriate to describe kitchen supplies: Monopoly, Oligopoly, Monopolistic Competition, or Perfect competition? Why?

2. While my shopping behavior was a bit different than most people for kitchen supplies, people do “search” when they buy certain goods. Name some items where the supply and demand model isn't as appropriate as a consumer search model would be. Why is it more appropriate to think about consumers searching for these goods?

3. An important part of search theory talks about the cost of searching. Suppose I didn't live near a shopping center and the stores were all 20 minute drives apart. How do you think that distance (and the opportunity cost associated with traveling between them) would change my behavior when I search? How would it change the pricing behavior of the stores?

Wednesday, March 06, 2013

A famous economics joke says it best: A physicist, a chemist and an
economist are stranded on an island, with nothing to eat. A can of soup washes
ashore. The physicist says, "Let’s smash the can open with a rock."
The chemist says, "Let’s build a fire and heat the can first." The
economist says, "Let’s assume that we have a can-opener..."

Though the above example is meant to be extreme, all economic models
are based on underlying assumptions. They may pertain to variety of things such
as the market structure, pricing mechanism, location, time lags, frictions,
mathematical properties, etc., and they are used to simplify economic
relationships. An important assumption
that drives many popular economic models is that of perfect information. In particular,
models rely on the assumption that the prices of all goods and services are
known.

As I was recently perusing the latest status updates of my Facebook friends, I noticed the following post: “How much do you pay a 14-year-old high school freshman as a mother’s helper a few days a week?”

As an economist, one might be inclined to quickly answer “whatever the
market price is for that service!” However, it is clear from this post that
that information is not actually known to the buyer.

While the internet has clearly helped to alleviate this information
gap, it can still take time to gather all the relevant information necessary to
make an informed decision. Sometimes, the cost of obtaining this information
becomes so high that consumers decide not to research at all. For example, if
you want to buy a hair dryer, a quick internet search may result in the same
model offered at different stores for different prices, so you still wouldn’t
know the relevant price for your needs without more digging.

Even though the famous supply and demand model does not completely reflect
the real world (since it assumes, among other things, that prices are known), this is not meant to imply
that economic models are worthless. It would be impossible to model every
detail of the “real world”; rather, it's important to make sure the assumptions
are appropriate for what you are trying to analyze. For example, if you’re
trying to model the effects of an increase in fuel price on consumers’ demand
for SUVs, assuming perfect information for prices does not invalidate the
results that it will decrease the demand for this good; it merely simplifies
the model into something tractable. But in general, you’ll want to ask yourself
the following questions when you examine an economic model: Are the assumptions
of this model reasonable? Would changing the assumptions affect the result in a
drastic way?

In short, be careful not to become a victim of assumption corruption, but
don’t let fear of assumptions keep you away from using models at all either!

Discussion Questions

1. Another popular assumption is that agents
act rationally and are utility-maximizers. How can this assumption still
be valid in the presence of people volunteering their time or donating
money?

2. Consider some other assumptions for the
supply and demand model, such as price-taking behavior or the competitive
hypothesis. How would relaxing those assumptions change the results of the
model, if at all?

Thursday, February 07, 2013

A few months ago, my car was burglarized; the side window was broken and my iPod taken. I had to pay $230 for the window repair and although the 2-year old iPod Touch may only have been worth $100, having it stolen was nonetheless very upsetting. On top of that, my husband had to spend $30 and two hours at a carwash cleaning up glass shards. At the end of the day, this crime incident cost my family about $360, not including the loss of time and music stored on the iPod.

Surprisingly, economic theory provides some comfort. According to the economic theory of crime and law enforcement advanced by economist Garry Becker in his famous 1968 article “Crime and Punishment: An Economic Approach” (www.jstor.org/stable/1830482), the societal cost of this crime is lower than the cost to me personally. Becker modeled societal losses from crime as the difference between damages brought about by criminal activities and gains to offenders, which can be summarized as follows:

Social Losses = Damages brought about by criminal activities - Gains to offenders

The complete theory accounts for the cost society bears to maintain the legal system and law enforcement, and also makes a number of important assumptions (for instance, that gains from crime are subject to diminishing returns). However, more importantly, the theory acknowledges that the person who stole my iPod is a member of society too, so although I lost a total of $360, not all of that value was truly lost. When formulated this way, the economic theory of crime enables law enforcement to calculate the “optimal” sanction. That is, when determining the level of resources to devote to crime prevention and punishment, society must weigh the benefit of reduced crime against the costs of law enforcement, incarceration, etc. If this equation ignores the gains to offenders, then the calculated level of punishment will be too high. Assuming the burglar can get $100 for my iPod and ignoring the value of the time spent on cleaning and the sentimental value of the lost music, the loss to society equals only $260. The optimal level of punishment for such a loss should therefore be lower than that associated with a true $360 loss.

Moreover, had the burglar been more skillful and stolen the iPod without breaking the car window, my loss would be exactly equal to the burglar’s gain. Certainly, I still would be upset, but in a larger scheme, this event would not create a noticeable effect on societal welfare. Well, the IRS would be unhappy about the situation too, although for a different reason. I can deduct my losses from the next year's taxes whereas, it is highly unlikely the burglar will ever report the gain as a taxable income.

Discussion questions:

1. If my burglar’s income is lower than my income and assuming diminishing returns to income, could this crime incident be viewed as a welfare improving redistribution of wealth?

2. Why wouldn’t societies be better off by increasing expenditures on law enforcement to such a level that there would be absolutely no crime?

3. Would societies be better off by adopting maximum punishment for all types of crime, violent and non-violent property crimes alike?